The First Fed Meeting of 2024

Join Andrew Wilkinson in an insightful conversation with Rareview Capital’s Chief Investment Officer, Neil Azous, as they dissect the market dynamics ahead of the January FOMC meeting. Neil shares his views on the Fed’s potential rate cuts, the delicate balance of the US economy, and why investors should consider both stocks and bonds in anticipation of policy shifts in 2024.

Summary – IBKR Podcasts Ep. 131

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Welcome to another IBKR podcast. My name is  Andrew Wilkinson. This week’s guest is Rareview Capital’s Chief Investment Officer, Neil Azous. Welcome back, Neil. 

Neil Azous 

Andrew, thank you for having me and great to be here with you ahead of the first Federal Reserve meeting in 2024. 

Andrew Wilkinson 

Indeed, we are going to be talking about events, the economy and the markets surrounding the January FOMC meeting. Now, for regular listeners, Neil has been a stalwart with us into every FOMC meeting last year and the year before, and we did that primarily because we’re in a tightening cycle. Neil, for much of 2023, your playbook depicted an end to monetary tightening and the onset of a loosening cycle and not a lot really deviated from that script to be honest. So as we head into the January FOMC press conference, where do you see us now? 

Neil Azous 

Sure, Andrew. Before commenting on what the market is pricing heading into the January 31st Fed meeting, I think it’s essential to first understand how we got here. So in early December, the Fed introduced or should I say reintroduced their workhorse model, called the Taylor Rule.  

Specifically, the Fed has used the Taylor Rule framework for decades to understand what the Fed funds rate should be. Today, if you insert the two major inputs into the Taylor Rule, which are the current level of inflation and the unemployment rate, it says that the Fed Funds Rate should be below 4.5% vs 5.5% currently.  

So in that spirit, at the December 13th Fed meeting, just over a month ago, the committee added three .25% interest rate cuts by September into their infamous dot plot. If you fast forward to now, the market is pricing about 1% of cuts by September, with a 50/50 chance of the first cut beginning in March.  

So at the same time, Andrew, the market’s pricing in two additional quarter point cuts between September 2024 and January 2025 for a total of 1.5% of cuts or six cuts at a rate of .25% each time. And this, Andrew, begs the question, why is the market getting out in front of the Fed? And to me that answer is pretty simple.  

Firstly, at this pace, the trajectory of inflation is set to fall closer to 1.5% by June. And there’s also at the same time an expectation of a continued, slow deterioration in the job market, which ultimately will raise the unemployment rate. So the Taylor Rule would show an even lower Fed funds rate if that plays out. And secondly, if the Fed raised interest rates by .75% four times in a row during the hiking cycle, Andrew, who is to say that each cut should only be .25% now? Why not a .5% or 1% along the way? Meaning there has to be some risk premium built in for that outcome.  

And then this is pretty basic, Andrew. Finally, once you start doing something, it’s pretty hard to stop. So if they start cutting, it’s difficult to stop. So that’s the market setup heading into next week’s Fed meeting. Andrew. 

Andrew Wilkinson 

Well, in the here and now and I think I asked you the same question in November. Is the current policy setting correct? Are we at the right level? Did they did the Fed do enough to  get the economy to slow down? 

Neil Azous 

So Andrew, our Federal Reserve investment process here at Rareview Capital is based on probabilistic outcomes. It’s quantitative. We don’t generally take a subjective or qualitative opinion on Fed policy or try to be a speech whisperer after every committee member speaks. That said, since you’re asking me for an opinion, I’m happy to provide one. I just want to put that caveat out there about how we go about things.  

So in that spirit, I believe the Fed knows it was way behind the curve when it came time to raise interest rates and they don’t want to repeat that mistake when it comes time to cutting interest rates. So by being preemptive or forward thinking, they’re increasing their chances of engineering a “durable” soft landing this time around.  

Secondly, as mentioned numerous times in the past on your show, the average time it takes to cut an interest rate is about 6.5 months after the last hike. So, in this instance, the last hike was at the July 25th meeting last summer, so that triangulates to around February 5th for the first cut. The market is pricing, as I mentioned, a 50/50 chance at the March meeting of that first cut. So that’s pretty close. That’s close enough for government to work, especially when you consider that the Fed now has eight meetings per year, but historically they only had four quarterly meetings.  

Also, it’s also important to note, Andrew, that the Fed has historically cut interest rates 2.4x faster than it raises rates because they have to recalibrate policy fast to counteract the financial accident that they created. And then finally, just more philosophically, Andrew, I think it’s long overdue that they reintroduced the Taylor Rule. If inflation does indeed undershoot their 2% target by June, they can easily fall back on that economic framework.  

And at the same time, it speaks to a return of normal policy instead of the extraordinary policy that they introduced after the global financial crisis. Meaning as an investor I would rather operate in those traditional frameworks that use the Taylor Rule than continue to think about policy in NIRP or ZIRP or QE or QT and forward guidance or whatever alphabet soup program they want to label it.  

Said differently, Andrew, I welcome the old days of policy and what we look like we’re going back to because it means it separates true market practitioners from those who got a free ride for a long time on these extraordinary policies that certainly, in my opinion, have overstayed their welcome. 

Andrew WIlkinson 

Neil- let me push back a little bit here. I mean, stocks during January spent the time setting record highs, at least in the case of the S&P 500. We’ve seen consumer confidence rebound and bond yields themselves stopped begging for an imminent cut in rates as you’ve just kind of outlined there. Talk to me a little bit about the development of the US economy and are we still left to see part of that monetary tightening bite harder? 

Neil Azous 

Andrew, I’m humble enough to say that I do not know the answer to that question with precision. But here’s what I think I know. Following the pandemic, the government created a lot of money and the market is still trying to figure out how to fit 10 lbs. of baloney in a 2 lb. bag. It’s clear that market agents, including ourselves, underestimated the amount of fiscal stimulus and the time it takes to absorb that size. My sense is that we’re closer to the end of that extraordinary support and the longer real interest rates stay up here, then there’s a greater risk of a financial accident happening. Here’s what I mean by that, Andrew.  

Back in 2006, 2007, the real interest rate or the difference between the nominal interest rate and inflation never reached more than 1.5%. Today, Andrew, that spread is closer to 3.5%. All I know is that the Fed is 2% tighter in “real terms” than they ever have been in the past. At some point, that restrictive policy has to bite and I believe the Fed knows this, and that’s why they reintroduced the Taylor Rule.  

So to my surprise, and hopefully to everybody’s delight, it appears that the Fed so far has engineered a soft landing. Yes, Andrew, there are risks that the economy veers off the runway into resurgent inflation or even a recession. But for now, those risks seem balanced. And they’re not unusually high. Therefore, the Fed does deserve a lot of credit and we should start cutting interest rates soon in line with their traditional economic framework being the Taylor Rule. 

Andrew Wilkinson 

All right, then. So beginning of the year, why should an investor put money, buy stocks at new highs or buy bonds in anticipation of easier policy later in 2024? 

Neil Azous 

My answer to that, Andrew, is and what we have been doing here at Rareview Capital is buying both stocks and bonds. On the stock side, we want to own global index beta as the S&P 500 breaks out of a two-year range. And when we combined the price to earnings ratio for the S&P 500, including the average of the trailing PE, the forward PE or the Cape, that composite is materially below the .com bubble and the pandemic liquidity peak. Therefore, we believe the index can appreciate based on that valuation potential.  

Secondly, this is important. But the overriding driver of stock market multiples during this period is really inflation, or in this case, now disinflation. The historical precedent, Andrew,  says that if CPI falls near the Fed’s 2% target over the next six to twelve months, the S&P multiple can expand by two to four more points. In this instance, it’s on its way to below 2% and may undershoot. So who’s to say that that multiple did not expand even more than that two to four points that historically has occurred? 

And then, Andrew, also to seek to generate some additional upside. We have overweight positions at the style level in US small caps and at the country level, we really like Japanese equities and Indian small caps. And then finally on the stock side, we believe it’s pertinent to add exposure to segments of the market that utilize leverage such as mortgage rates and closed end funds. 

Very simply, as financing costs drop, following Federal Reserve interest rate cuts, those types of products should get an added boost. On the bond side, Andrew, there’s no need to overthink things. If the Fed is cutting rates, you want to sell out of your T-bills or cash like instruments and buy longer dated fixed income such as a three-to-five-year bond. And additionally for us, you know, if you have this capability, we have added exposure to the US Treasury yield curve steepening. We believe that the yield curve coming out of the deepest inversion in history will be the “alpha” trade of the year in fixed income.  

And finally, I’d just like to leave you with this reminder. You only get one chance to come out of a rate hiking cycle, so don’t squander it by overthinking it when it comes to being long bonds now. 

Andrew Wilkinson 

My guest today has been Neil Azous, CIO and founder at Rareview Capital. A huge thanks for joining me again today, Neil. 

Neil Azous 

My pleasure, Andrew. Thank you for having me and best of luck in 2024. 

Andrew Wilkinson 

Thank you. And the same to you. And folks, if you enjoyed today’s edition, please don’t forget to subscribe and leave us a review wherever you download your podcasts from.